IRS Private Letter Ruling Concludes Liquidated Damages Do Not Affect REIT Income

In a recent IRS Private Letter Ruling, the implications of liquidated damages on REIT income tests have been clarified. In this article, we examine the details of this ruling and analyze how it preserves REIT tax benefits without compromising their financial strategies.  

Key Takeaways  

• A recent IRS Private Letter Ruling clarified that liquidated damages and related legal fees do not count towards REIT income tests, thus preserving the tax benefits of REITs.  
• The ruling emphasizes that amounts derived from real estate-related activities, even when resulting from legal settlements, should not compromise a REIT’s tax status.  
• This decision offers insight into IRS interpretations, potentially influencing future tax planning for REITs, especially in scenarios involving non-traditional income events like liquidated damages.  

What is a REIT Income Test? 

Real Estate Investment Trusts (REITs) must satisfy several requirements to maintain their tax-advantaged status. One such requirement is the gross income test under Internal Revenue Code Sections 856(c)(2) and (3).  

Under these rules, at least 75% of a REIT’s gross income must be derived from real estate-related sources - such as rents, mortgage interest, gains from property sales, and other qualifying items.  

In addition, at least 95% of a REIT’s gross income must come from these real estate-related sources plus certain other passive income items, such as dividends and interest.

Case Overview: How a Failed Property Sale Triggered Liquidated Damages  

A REIT that owned a portfolio of multifamily rental properties entered into an agreement to sell the entire portfolio. The anticipated gain from the sale would have been qualifying income under the 75% gross income test described above. As part of the agreement, the buyer deposited a substantial non-refundable amount into escrow to be applied toward the purchase price. The buyer ultimately defaulted, and the transaction did not close.  

Pursuant to the sale agreement, the REIT/seller became entitled to the deposit as liquidated damages. After several years of litigation, the deposit was released to the REIT/seller, along with an award of legal fees related to enforcement of the contract. 

IRS Ruling: Why Liquidated Damages & Legal Fees Don’t Count Towards REIT Income Tests  

If the forfeited deposit and legal fees were taken into account for purposes of the gross income test, they may have been considered non-qualifying income. In PLR 202522001, however, the IRS exercised its discretionary authority under Section 856(c)(5)(J) to exclude both the liquidated damages and the legal fees from the gross income tests. As a result, these amounts were excluded from both the numerator and denominator when calculating the REIT’s qualifying income percentages.  

The IRS based its decision on the legislative intent behind the REIT income tests, which are intended to ensure that most REIT income is derived from passive sources and not from the active conduct of a trade or business. The liquidated damages arose directly from a failed disposition of real estate - an activity consistent with the REIT’s intended purpose. Therefore, penalizing a REIT for pursuing legal remedies related to a permitted transaction would not further the policy objectives of the income tests. 

What This IRS Ruling Means for REIT Income Qualification 

While private letter rulings apply only to the requesting taxpayer, they offer valuable insight into the IRS’s interpretation of complex tax issues. This IRS ruling illustrates that, in certain circumstances, unexpected receipts such as liquidated damages may be excluded from the gross income tests if closely related to the REIT’s passive real estate activities and where inclusion would not advance the purposes of the REIT qualification regime.